Abstract
This paper provides a new perspective on the relationship between exchange rate fluctuations and business cycle dynamics by focusing on the underlying macroeconomic shocks. We study how domestic and global macroeconomic shocks, which we identify using zero and sign restrictions, are transmitted through exchange rate adjustments in 8 small open economies. Based on a counterfactual analysis, we find that the capacity of the exchange rate to absorb business cycle fluctuations depends on the underlying shock and differs across the short and the medium run. Following domestic aggregate demand shocks, endogenous exchange rate dynamics stabilize real GDP, primarily in the short run, and inflation dynamics over the medium run, while they amplify the effects of monetary policy shocks. Following domestic aggregate supply as well as global shocks the exchange rate exerts only small effects.
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